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Bloomberg says that some pundits are beginning to contemplate the possibility that the Fed’s next move might be up, not down:
Summers, a Harvard University professor and paid contributor to Bloomberg Television, suggested a perhaps 15% chance that the next Fed move is an increase. Mark Nash, who manages absolute return macro funds at Jupiter Asset Management, puts the odds at 20%.
Even some who do expect rate cuts have advocated taking out insurance on that bet. BMO’s Davis has been shorting two-year Treasuries since December, though covered half of that position amid the climb in rates since the start of the year.
At Societe Generale SA, Chief FX Strategist Kit Juckes told clients in a report last week that if “the US economy re-accelerates, the Fed will eventually have to tighten again and the dollar will rally,” possibly back to 2022’s all-time high.
Clearly, the markets believe the next move will be toward lower rates, but no one should be surprised by the fact that a rate increase is possible. In an efficient monetary policy regime, there would be roughly a 50-50 chance of a rate increase on any given day. (Under an efficient regime, policy would set the target fed funds rate to the nearest basis point, and that target would be adjusted daily in response to a continual flow of new information.)
Even with our current inefficient regime, policy moves should be at least somewhat unpredictable. For simplicity, define easy money as a policy rate below the natural rate and tight money as a policy rate above the natural rate. If the central bank is trying to set rates at the (unobservable) natural rate of interest, then they would be expected to overshoot 50% of the time and undershoot 50% of the time. More importantly, the errors made by a rational central bank should be completely uncorrelated with the level of interest rates.
This means that you would not necessarily expect a high interest rate policy to be any more contractionary than a low interest rate policy.
Of course you can imagine models where high rates are correlated with tight money, as in the case when the central bank intentionally sets rates above their estimate of the natural rate in order to control inflation. But in general, policy errors should be uncorrelated with the level of rates. So “make up” policies to correct previous policy errors should be hard to forecast.
The Fed has now set rates at a level expected to produce a soft landing. If they overestimated the natural rate of interest they might deliver a hard landing, and if they underestimated the natural rate we might get no landing at all. In the latter case, inflation might stay stubbornly above target, requiring further rate increases.
Two years ago, almost no one correctly forecast the recent path of interest rates. The same could be said about interest rate forecasts in early 2020, or early 2019. I don’t know what will happen to rates over the next two years, but I have very little confidence that things will play out in the way the markets or the Fed currently expect. There could be surprises in either direction.
I see people cherry-picking some obscure inflation metric which has hovered around 2% for 6 months. But price inflation is not the right variable to look at. In order to have lower interest rates, we need a slowdown in wage inflation and NGDP growth. If wage inflation gets stuck at 4.5%, then interest rates are headed higher. I still think it’s likely that wage inflation will slow, but recent price inflation moderation doesn’t reassure me at all.
In an efficient monetary regime (NGDPLT), policy errors in either direction would be equally bad. But we don’t have level targeting. In addition, recent policy errors have been in the direction of an excessively expansionary policy. For that reason, the damage from a somewhat overly expansionary policy in 2024 would be greater than the damage from a somewhat overly contractionary policy in 2024. The longer that wage inflation stays elevated, the more difficult it will be to bring it down.
PS. Here’s the FT:
Earlier this month, Australia’s central bank — the Reserve Bank of Australia — decided to keep its main interest rate on hold at 4.35 per cent. Nothing alarming there. But in a statement, rate setters indicated that the next move could conceivably be up, not down. . . .
Assumptions for swift rate cuts are also on shaky ground in New Zealand. Last week, regional bank ANZ flipped its view on what the Reserve Bank of New Zealand will do next. As recently as January, it thought the central bank would start pruning rates back in August. Now it is forecasting two more rate rises by April, taking the benchmark rate to 6 per cent.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
